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All investors should be familiar with the financial bubble phenomenon and understand how to recognize and avoid it.
Financial bubbles are typically identified only after they collapse.
It is crucial to understand how investment opportunities are created and what signs investors should look for to avoid unexpected losses.
This article will explain the concept of financial bubbles and provide guidance on recognizing them.
What is a financial bubble?
A financial bubble occurs when the price of an asset rises significantly without a corresponding increase in its actual value, driven by the expectation that the price will keep going up.
People are willing to pay higher prices in anticipation of selling for a profit, leading to a cycle of increasing prices until reality sets in and the bubble bursts.
What causes bubbles to form?
There is no commonly accepted theory that explains the rapid and unsustainable growth of certain assets.
One explanation suggests that when the economy picks up speed, businesses show increased profits and offer higher salaries to employees.
People often end up spending more than they should, such as purchasing a house that is out of their financial reach, with the belief that rising prices will make it easier to afford.
They might be more likely to take risky actions in the stock market, triggering a chain reaction that results in a financial bubble.
An alternative explanation suggests that when the economy grows, more money is added to the financial system, making borrowing more affordable. This leads investors to take advantage of low interest rates by borrowing money to invest in various assets.
When investors heavily invest in a small number of assets, prices increase, leading to a classic bubble when this behavior is multiplied across numerous individuals and large institutions.
Nevertheless, these theories, along with others, do not provide a definitive explanation as various factors come together to create a financial bubble.
Formation of financial bubbles
If something is limited and sought after, it will have a value. Having a value can lead to a speculative frenzy, such as with assets like stocks, property, metals, and resources. However, if this value collapses, it is considered a bubble.
Financial bubbles are not as direct and predictable as portrayed by the media, with complex causes and the likelihood of expert predictions not materializing.
Worldwide economic bubbles
The 1929 crisis
The financial market has experienced various financial bubbles, such as the 1929 crisis.
Both inflation and speculative bubble bursts were fueled by the increased use of leverage, which refers to debt taken on by individuals and companies.
During this time, there was a significant increase in consumer credit usage for buying new products and investing in stocks as the stock market expanded, with investors leveraging loans from brokers.
Dow Jones hit its peak in 1929 before the stock market slowdown began, with “Black Thursday” on October 24 marking the start of the 1929 crisis.
Around 13 million shares were exchanged during a day of unexpected panic that impacted the markets. The Dow Jones index dropped by 38 points on Monday, October 28, and then another 30 points during the notorious “Black Force” on October 29, with a remarkable 16.5 million shares traded. Following the tumultuous events of October, the market experienced a brief recovery in the spring of 1930 before facing another crash in the early 1930s.
Tulip cake
Another bubble that marked a significant moment in the history of major stock market bubbles globally was the tulip bubble.
The tulip bubble was a financial event in the Netherlands during the 17th century that created the first recorded speculative bubble.
The tulips became the focus of intense speculation, leading to a frenzy that escalated quickly and resulted in a surge in bulb prices, which is now known as the tulip mania.
When the bubble burst, the crash ensued, causing the tulips to depreciate and traders to collapse, leading to a Dutch economic crisis.
Online cake
The internet bubble, also referred to as the dot-com bubble, was a speculative trend in the stock market involving internet-based or technology-focused companies during the early 2000s.
Cake made of Bitcoin
The market experienced the bitcoin bubble in early 2017, with the price of bitcoin starting below US$ 1000 and peaking above US$20,000 by the end of the year. However, the value plummeted by 72% in the subsequent year.
Financial bubbles formation
It is crucial to learn how to recognize potential financial bubbles, which are typically linked to three key features of the assets.
- commercial sale;
- money and credit sources
- Speculation.
Marketing refers to the convenience of buying and selling an asset, making a legally tradable asset more probable.
An asset that can be divided into smaller units also enhances trading convenience.
It is important to have convenience in finding a buyer or seller and in marketing the asset.
A bubble can only develop when there is sufficient capital available for investment, which is more probable when there is a surplus of money and credit circulating in the economy.
Low interest rates and easy access to credit are more likely to encourage the growth of bubbles as they can prompt investors to pursue higher returns and invest in riskier assets.
Speculation is a constant presence, with investors ready to purchase downtown properties and sell them at a profit.
During a bubble, investors often shift from investing to speculating, trading based on short-term price movements.
These three factors are essential but insufficient to cause bubbles.
Vernon Smith, Nobel Prize winner, believes that it is difficult to predict the emergence of bubbles.
Identifying the risk of bubbles
Any savvy investor must understand that predicting the exact moment when the financial market will change is impossible. Hence, it is crucial to implement strategies that minimize investment risks.
One suggestion is to modify the risk level of your investment portfolio while maintaining the appropriate mix of assets through diversification. Find out more here.
To detect bubble risk, it is important to examine if the multiples of a stock are deviating from the norm. This involves evaluating the P/L ratio, which compares the stock price (P) to the company’s profit (L).
The investor should evaluate if any underlying shift justifies the price’s behavior when it exceeds the paper’s historical highs.
The rise in profit/loss is seen as a reliable sign for spotting bubble risk, but it is crucial to analyze a company’s underlying fundamentals and invest prudently instead of speculating.
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In conclusion
The primary characteristic of a bubble is the quick increase in the market worth of an asset or assets, but it is still unclear what specifically triggers this surge.
Investors who follow the trend of an asset and engage in trading contribute to the formation of a bubble. Hence, it is essential to educate oneself and thoroughly research to choose the right asset for safe and successful investments.
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